Thursday, August 20, 2015

It is a sign of the low volatility 2015 environment that when the SPX falls by 4.5% on a peak-to-trough basis, there is a sense of panic in the air. With the SPX at 2035.73, traders have to decide whether this is the start of a major correction or a short-term capitulation bottom in stock prices.

The bear case
With the market down about 2% today, the bear case is easy to make.

China seems to be unraveling again (see my previous post Is China getting hit with THE BIG ONE?). Not only is the Shanghai Composite testing its 200 day moving average (dma), the stock indices of major Chinese Asian trading partners are all trending downwards, which indicate economic weakness.

Junk bonds are performing badly, which is reflective of a deterioration in credit market risk appetite.

The technical conditions of the stock market are awful.

I have written much about how market breadth has been deteriorating and price momentum flagging (see Bullish and bearish over different time frames). Indeed, a number of key technical "lines in the sand" have been breached. Mark Hulbert highlighted the fact that the Dow Theory has just flashed a sell signal. The chart below shows that the SPX fell below its 200 dma and violated a key support level at 2040.

To be sure, the above chart also shows that both the RSI(5) and RSI(14) momentum indicators are in oversold territory. However, oversold markets can get even more oversold. It comes to the same question of whether the bears have seized control of the tape.

An oversold market
In addition, to the RSI indicators shown in the chart above, numerous breadth indicators from IndexIndicators are flashing oversold readings (where the dots indicate my own estimates). This chart of SPX stocks above their 10 dma, which is a short-term indicator with a 1-3 day time horizon, are at levels where the market has bounced before in 2015.

Longer term indicators (about 1 week horizon) such as the net 20-day highs-lows are at oversold extremes.

Even longer term indicators (1-3 weeks) like the net 50-day highs-lows are telling a similar story.

"Smart money" buying, "dumb money" in crowded short
Despite the negative tone shown by the market, bulls can be comforted by the actions of "smart money", or company insiders. The latest Barron's insider trading report, which is updated each weekend, shows that insider trading has been flashing a more or less continuous buy signal since mid-July.

Many sentiment models are flashing crowded short readings as well. The NAAIM exposure report is at levels seen in recent lows, though RIAs did get even more bearish at the October 2014 lows.

Chad Gassaway also pointed out that the Daily Sentiment Index (DSI) is at bearish extremes, which is contrarian bullish.

I have also pointed out before that the 10 dma ISE equity-only call/put ratio, which measures customer only opening option transactions, recently hit an all-time low, below the levels seen during the 2007-2008 bear market. The next high reading was seen on March 20, 2008 - and the SPX rallied by 10.8% before falling further into its Lehman Crisis low (see full analysis at Groundhog Day).

Speaking of options, the latest 21 dma of the CBOE equity-only put/call ratio hit highs last seen in late 2012. I have highlighted past peaks of this ratio, which have coincided with market bottoms.

In summary, while market internals and momentum are calling for a continuation of a market decline, sentiment, sentiment models are at bearish extremes, which is contrarian bullish. How can we explain this apparent conflict between technical and sentiment analysis?

A bounce first, then decline
On one hand, the technical structure of the market is highly suggestive of lower stock prices in the next few months. On the other hand, sentiment conditions point to a market rally for the next 1-3 weeks.

One clue to resolve this problem can be found in the above chart of the 21 dma of the CBOE equity-only put/call ratio. This ratio hit a high in the summer of 2011, where the market rallied and then fell into its ultimate low for that year. I believe that is the most likely analogue for the current conditions of the stock market.

Otherwise, we are left with a second possibility that these extreme sentiment measures resolve themselves with the market bottoming in the next few days and rallies to put us back into the same old frustrating range-bound conditions seen in all of 2015.

As for what is likely to happen next, here is my roadmap, which can change as market conditions change. My trifecta model (described at Time for a market bounce?) shows the short-term technical conditions of the market. The term structure of the VIX Index has inverted, indicating heightened fear. On the other hand, a TRIN spike over 2 hasn't happened yet, which can be indicative of a "margin clerk" forced liquidation market which washes out the weak holders. The last Trifecta component, the intermediate term OBOS model is nowhere near an oversold reading of 0.5. Usually, we need to see two of the three Trifecta elements flash buy before a durable bottom can be (on a multi-week time horizon).

My base case scenario calls for the current combination of oversold and crowded short readings to spark a market bottom in the next few days, after which the market will see a melt-up recovery. The resulting rally will flush out any bears who are short, which gives room for the intermediate term technical indicators to push stock prices into their long awaited final correction.

In other words, expect a market of maximum frustration for directional traders in the coming weeks. In the meantime, I will be watching my Trifecta model very carefully for signs of capitulation.

3 comments:

Yup, you're pretty much spot on there, and thanks for the sentiment analysis. Sentiment's almost as bad as it was last October when the Ebola panic was in full swing, and yet we're going to get a dovish Fed position in September.

BTW I don't know if the stockcharts.com figure is accurate, but it says $TRIN spiked at 4 today.

Nice summary! I'm sitting on the sidelines until I have a clearer sense of the market's future course. I saw your tweet in regard to the TRIN indicator and the VIX:VXV ratio, and I hope you are right, but I think I need more before taking a position.RAS

For now there already in SP@500 correction is approximately 7%. In last years all corrections ended within 10% (except - 2011). March-June 2012 was 11%, but it took 2 months here. So, for now we already have 7% correction and from your great analysis we see that almost all indicators are oversolded - also VIX already is almost 25, so much fear here. But not so much fundamental problems if FED will delay rate hike until december - China had problems, but probably if here we will see 4-5% growth rate it`s not apocalypsis :). US economy also is not bad, greece fears i think overdone, junk bonds main problems is in energy sector. So - if we will have bounce at next week and after that big correction, how much it can be - 15%? Or you think there will be W shaped market?

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

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